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Totalization Agreements: Taking Exception to Social Security

By Kathy Mort, CPA, Pittsburgh

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Tax Section

Editor:
Annette B. Smith, CPA

Employment
Taxes

For FICA tax purposes, “wages” are defined
in Sec. 3121(a) as all remuneration for employment.
Sec. 3121(b) defines “employment” for purposes of FICA
generally to include any service performed by an
employee for an employer, irrespective of the
citizenship or residence of either, within the United
States, or any service performed outside the United
States by a U.S. citizen or resident as an employee of
an American employer. There are also specific rules
(beyond this item’s scope) related to services
performed on or in connection with certain American
vessels or American aircraft and any service performed
under an agreement entered into under Section 233 of
the Social Security Act, P.L. 74-271.

Without a
specific exception, these broad definitions of wages
and employment operate to extend U.S. Social Security
to American citizens and U.S. resident aliens employed
abroad by American employers without regard to the
duration of an employee’s foreign assignment and even
if the employee has been hired abroad. Employers may
be unaware that nonresident alien employees or foreign
employees who have been sent to work within the United
States for any length of time generally also are
covered under the U.S. program. In addition, many
American companies enter into agreements with the
Treasury Department under Sec. 3121(l) to provide
Social Security coverage for U.S. citizens and
residents employed by their foreign affiliates.

These rules, in combination with the fact that most
countries impose social taxes on persons performing
services in their territory, often result in dual
social tax liability. This occurs when a worker from
one country works in another country and is required
to pay social taxes to both countries on the same
earnings.

Totalization
Agreements

The statute and regulations include
several exceptions from FICA liability. One exception
applies to certain wages paid during any period in
which there is in effect an International Social
Security agreement, often called a “totalization
agreement.” Sec. 3101(c) (for the employee portion of
FICA) and Sec. 3111(c) (for the employer portion of
FICA) provide exemptions for wages received by or paid
to an individual during any period in which there is
in effect an agreement that those wages are subject
exclusively to the laws applicable to the social
security system of the foreign country. The following
24 countries have entered into totalization agreements
with the United States: Australia, Austria, Belgium,
Canada, Chile, the Czech Republic, Denmark, Finland,
France, Germany, Greece, Ireland, Italy, Japan,
Luxembourg, the Netherlands, Norway, Poland, Portugal,
South Korea, Spain, Sweden, Switzerland, and the
United Kingdom.

A totalization agreement is
intended to eliminate dual social taxation and to
provide additional benefit protection for workers who
have worked in both the United States and another
country. The provisions eliminating dual coverage for
employed persons are similar in all U.S. totalization
agreements, each of which establishes a
“territoriality” rule that looks to the location of a
worker’s employment. Under this rule, a worker who
would be eligible for coverage under both the U.S. and
a foreign social system will be subject only to the
coverage laws of the country where he or she is
working.

However, except for the agreement with
Italy, there is an exception to the territoriality
rule in each agreement for workers sent abroad on
temporary assignments. This “detached-worker”
exception is designed to minimize coverage
disruptions, and under it a person temporarily
transferred abroad to work for the same employer
remains covered by the country from which he or she
was sent. Therefore, a U.S. citizen or resident who is
temporarily transferred by an American employer to
work in one of the 23 countries that have entered into
agreements (excluding Italy) continues to be covered
by U.S. Social Security and is exempt from coverage
under the host country’s system. In that instance,
under the agreement, the employee and employer pay
U.S. FICA tax on the employee’s wages and not social
security contributions to the host country.

While eliminating dual social taxation in many
instances, the detached-worker rule has significant
limitations. First, it does not permit dually covered
employees or their employers to choose among social
tax systems. Rather, the agreements simply exempt
workers from coverage under the system of one country
when their work otherwise would be covered under both
systems. Second, the rule requires that covered
employees continue to work for the same employer when
on assignment in another country. This means that the
common-law analysis of whether an employer is truly an
employer applies and that the employer cannot be
identified simply by contract or some other means.
Employers must actually direct and control their
employee. Finally, while the definition of “temporary”
may vary, most U.S. agreements apply to employees
whose assignments are expected to last five years or
less.

Totalization agreements also can assist
workers who, because they have split their careers
between the United States and a foreign country, do
not meet the minimum eligibility requirements to
qualify for benefits in one or both countries. A
totalization agreement may allow those workers to
qualify for partial U.S. or foreign benefits based on
combined, or “totalized,” coverage credits from both
countries.

To document their exemption from U.S.
or foreign social taxes under a totalization
agreement, employees must obtain a certificate of
coverage from the country that will continue to cover
them. When employers transfer employees abroad, they
are generally required to request certificates on
behalf of those workers. An employer is authorized to
stop withholding and paying U.S. Social Security taxes
on the employee’s earnings when it receives a
certificate establishing that the employee is covered
by the foreign system. Employers should retain the
certificate in their files to produce in the event of
an IRS examination or other inquiry.

In
summary, totalization agreements may reduce the costs
of an international assignment and protect employees
who otherwise would lose social benefits due to
international assignments. Employers should ensure the
rules under totalization agreements are being applied
properly and that the required documentation is
acquired and retained.

EditorNotes

Annette Smith is a partner with PwC, Washington
National Tax Services, in Washington, D.C.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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